While I don’t know for sure as I haven’t seen any link/reference to the claim but I suspect Chris is right that a large proportion of options expire worthless … it certainly is true in my case when I buy options …
#@$%^&*#$%%^ ha ha ha
On the subject of covered call option, here’s a very good explanation of how to use this strategy to supplement a buy-and-hold one from Trend Rider. It essentially allows you to turn the normally undesirable time decay effect to your own beneifts:
Profit from the Trend:
“Become the Casino” with this simple options strategy …
Chris Rowe
To understand why you should make covered calls a regular part of your investment diet, ask yourself one question:
Why does a casino make so much money?
Because there are millions of people who are okay with taking bets, even when they know that the odds are against them. Every now and again, the casino loses and the gambler wins!
But does the casino ever really lose? I mean, is the casino really gambling at all?
The guests of the casino are doing all of the gambling. The casino is simply running a business. The casino knows that every now and again they will have to pay up. But the amount that they pay out once in a while is dwarfed by the amount that they collect from most of the other guests. Everyone knows that!
But when you are the buyer of short-term, out-of-the-money options, you might not realize that you are the same guy as the gambling casino guest.
When you are the person who is selling (aka writing) covered calls, YOU are the casino!
You are the one who is accepting payment after payment after payment from the guy who wants to see his $2.00 BOBC call option trade up to $10.00.
Once you have sold a covered call and received your payment, either you will keep the premium and your stock position, or else you will keep your premium, and you will sell your stock. BIG DEAL! Just be sure to sell covered calls only if you are willing to sell your stock at the strike price.
Ideally, you want to sell calls with a strike price that’s slightly higher than the stock’s current price. It’s also okay to sell calls with a strike price that’s at-the-money (the same as the stock’s current price) or slightly in-the-money (slightly lower than the stock’s price.) The idea is to profit from the decaying time value of the option that you have sold.
Ideally, you also want to sell calls that will expire in 30-45 days because that is when time value will decay most rapidly.
Now for the comparison:
Let’s say you are NOT that average stockholder (who never sells covered calls.)
Instead, you have taken the time to learn about covered calls, and you now have the advantage of an easily acquired education on the benefits of covered call writing …
You buy 1,000 shares of “Bob’s Car Wash” (BOBC) at $50.00 per share.
The stock now trades to $58.00 per share.
You say to yourself: “I would be willing to sell my stock at $60.00. Let’s see what the BOBC June 60 call options are trading at,” because you know that someone is willing to pay something for the right to buy your BOBC at $60.00.
You find out that you can sell the BOBC June 60 calls for $2.00.
Again, the stock is at $58.00, and so far you are up $8,000.00 on your stock position.
Remember these two keys:
Each option contract represents 100 shares. 10 option contracts represent 1,000 shares. So if you own 1,000 shares of BOBC, and you want to sell someone the right to BUY your 1,000 shares of BOBC, then you would sell 10 call options (to open,) because 10 options represents 1,000 shares.
Some people get confused about selling first and buying second. Traditionally people are trained to understand only buying something first and selling it second. But when you write an option contract (or sell an option contract,) then you are essentially “short” the option contract. You can first sell an option contract at $10 (to open,) and THEN buy the option 3 weeks later at $6 (to close) for a 4-point profit.
So again, BOBC has traded from $50.00 to $58.00 per share.
This time you sell 10 June 60 call options (to open), and you receive an extra $2.00.
That part of the transaction is now done. You now have an extra $2,000.00 in the bank, no matter what happens to the stock.
Now take a look at the difference.
There are four possibilities:
BOBC trades to $60.00+. Your BOBC is called away (sold) at $60.00 per share, and instead of $10,000.00, you net a profit of $12,000.00. ($10k on the stock and $2k on the option that you sold.)
Special note: Your stock will not necessarily be sold at $60.00 just because it trades over $60.00. Your stock may or may not be called away at any time before expiration. If, at 4:00 p.m. on expiration day, the stock is 25 cents in-the-money, or more (which means BOBC would be at $60.25 or higher), the call that you sold will automatically be exercised, and your stock will automatically be called away (sold).
Here is a quick picture of what this would look like.
BOBC trades down. You don’t feel so bad because you picked up that extra $2,000.00. If you didn’t sell that call option, BOBC would have still traded lower, but your account would be worth $2,000.00 less than it is worth right now! Whatever dollar amount the stock trades down by, the decline in value is reduced by $2,000.00.
For instance: If, after you take in that $2.00 premium, your stock trades from $58 down to $55, then instead of losing $3,000.00 in value, your 1,000 shares of BOBC would lose $1,000.00 in value since you will have been paid $2,000.00 for the call option that you sold. (If the stock trades down 3 points, you really only lose 1 point in value, because while the stock lost 3 points, you made 2 points by selling the call option.)
At least you take in an extra $2,000.00, and you will be free of any future obligation once the option contract expires. (Or else you can just close out the call option position by buying the same call back (to close) at its current lower price (see below).
Now here’s a fun twist: You actually have two choices if your stock trades lower.
a) You can do nothing and maintain both the “long” stock position, as well as the “short” call option position until the option contract expires.
b) You can simply buy the option contract (that you previously sold at $2.00) at a cheaper price. Imagine selling a gold watch for $2,000.00 and then buying it back from the person that you sold it to for $300.00. Not bad. That’s a $1,700.00 profit.
As the stock trades lower, the call option that you sold also trades lower. That means that if the stock trades lower, you can always buy the call option (that you’ve sold) at a cheaper price than what you received for it when you sold it. This is a profit on the option trade that will reduce the loss incurred on your stock position.
For example: If BOBC trades from $58.00 down to $55.00, then the call option that you sold at $2.00 (to open) may trade down to 30 cents. You can now buy the call option at 30 cents (to close). That’s a difference of $1.70. Since you originally sold (or shorted) that call option at $2.00, that $1.70 difference is a profit.
Said differently, if BOBC traded from $58.00 to $55.00 the stock position lost $3.00 in value. But since the call option that you sold at $2.00 (to open) is now at 30 cents, you have a profit of $1.70. So the net result is that, instead of your position losing $3.00 in value, it really only lost $1.30 in value.
Stock lost $3.00
Option gained $1.70
Total loss is $1.30
OR – as I said originally, you can let the option expire worthless and realize the entire $2.00 gain on the call. In this case, if the stock traded from $58-$55, then your entire position would have lost $1.00 in value instead of $3.00.
Stock lost $3.00
Option gained $2.00
Total loss is $1.00
After the option expires, you are free of your obligation. If you wish to do so, you can sell another call option and start the process over again.
BOBC doesn’t trade up or down, but sideways. GREAT! As time passes, the call option that you sold (to open) is losing its time value. Since you are “short” the call option, this is a good thing for you. Basically, as time goes by with the stock trading flat, you are making money as the call option loses value due to time decay.
If the stock pretty much trades flat until the option expires, even though the stock did absolutely nothing, you made an extra $2,000.00. This is awesome! Even though the stock never got to $60.00 per share, you still made $10,000.00 as you had originally hoped for! (You made $8,000.00 on the stock and $2,000.00 on the call option that you sold.)
Meanwhile, there is someone out there who was in the same position as you, but since they didn’t sell covered calls, they are sitting on a $58.00 stock, wondering whether or not it will trade to their target price of $60, so that they can make the $10,000.00 that you just made with zero movement in the stock.
The call option expires worthless, you now have two choices: You could either sell BOBC at $58 and skip down the street thinking about how cool you are for making $10,000.00 on a stock that only traded up 8 points, or you could sell another call (to open) that expires the following month or two out. Maybe you can sell the July 60 call (to open), or the August 60 call (to open) and take in yet another extra premium.
BOBC trades somewhere between $58 and $59.99. GREAT! I can’t wait to brag! Let’s say, for example, the option expires worthless, and BOBC is at $59.00 at the time. That means that you made $2,000.00 by selling the call option (you had sold that casino guest the right to buy your BOBC at $60,) and you are also up 9 points on the stock. If my calculations are correct, you are now up $11,000.00, and the stock never even hit your price target of $60.00!
So the moral of the story is this:
When you are long the option contract (said differently: when you are the owner/buyer of the option contract), Time Decay is your worst enemy, because as time passes, your option loses value.
When you are “short” the covered option contract (said differently: when you are the writer/seller of the covered option contract), Time Decay is your best friend, because as time passes, the option that you sold (to open) to someone else, loses value. You can either buy the option back (to close) cheaper, which will result in a profitable option trade (offsetting your stock’s loss of value), or you can let the option expire … which will also result in a profitable trade.
If this covered call lesson has helped you learn something new, then you are probably anxious to get out there and write some covered calls on stock that you own, and start grabbing all of that extra money that you have been leaving on the table each month. But before you do, first consider this last possible outcome …
What would happen, and how do you think you would feel, if you wrote a covered call on BOBC, which obligates you to sell BOBC at $60.00 per share, but 2 weeks later BOBC traded up to $90.00 per share? Hmm.
Before you read any further, think about that for a minute. Do you know what would have to happen in that case?
Well here it is: You would have to sell BOBC to someone at $60.00, even though it is selling at $90.00 in the stock market. Now, that might drive you crazy, even though your original plan was to sell at $60.00 anyway.
Ask yourself, how much of a loser would you feel like if you sold someone the promise that they could buy your stock at $60, only to see it trade to $90, 2 weeks later?
Answer: You should feel like a loser much as the casino feels like when someone puts $2.00 in a slot machine and wins $30.00.
The reason a casino is happy to give up a profit every once in a while is because they make so much more in the long run.
I hope that I have given you a clearer picture of why options can be used as a way to gamble, but also as a conservative way to reduce risk.
Chris Rowe
Chief Investment Officer
The Trend Rider
